Question

Approximately Relevant ABC

Silven Company has identified the following overhead activities, costs, and activity drivers for the coming year:

Silven produces two models of cell phones with the following expected activity demands:

Required:

1. Determine the total overhead assigned to each product using the four activity drivers.

---

2. Determine the total overhead assigned to each model using the two most expensive activities. The costs of the two relatively inexpensive activities are allocated to the two expensive activities in proportion to their costs.

---

3. Using ABC as the benchmark, calculate the percentage error and comment on the accuracy of the reduced system. Explain why this approach may be desirable.

Answer 1

We are given the overhead activities, costs and activity drivers for S Company. We are required to determine total overhead assigned to each product.

1. Total overhead cost are assigned to each product using the four activity drivers as follows:

	Model X	Model Y
Setting up equipment	84,000	42,000
	($840 * 100)	($840 * 50)
Ordering materials	6,000	12,000
	($20 * 300)	($20 * 600)
Machining	72,000	54,000
	($12 * 6,000)	($12 * 4,500)
Receiving	9,000	21,000
	($24 * 375)	($24 * 875)
Total overhead cost	171,000	129,000

Overhead rate is calculated as follows:

Activity	Expected Cost	Activity Capacity	Overhead Rate
	(A)	(B)	(A/B)
Setting up equipment	126,000	150	$840 per setup
Ordering materials	18,000	900	$20 per order
Machining	126,000	10,500	$12 per machine hour
Receiving	30,000	1,250	$24 per receiving hour

2. Total overhead cost are assigned to each product using the two most expensive activities as follows:

	Model X	Model Y
Setting up equipment	100,000	50,000
	($1,000 * 100)	($1,000 * 50)
Machining	84,000	63,000
	($14 * 6,000)	($14 * 4,500)
Total overhead cost	$184,000	$113,000

Overhead rate is computed as follows:

Activity	Budgeted Activity Cost	Driver	Quantity	Overhead rate
Setting up equipment	150,000	Number of setups	150	$1,000 per setup
	[$126,000 + {(126,000/252,000)*48,000}]
Machining	150,000	Machine Hours	10,500	$14 per machine hour
	[$126,000 + {(126,000/252,000)*48,000}]

3. Percentage error is computed as follows:

	Model X	Model Y
Overhead using ABC system	171,000	129,000
Overhead using reduced ABC system	184,000	113,000
Difference / Error	13,000	-16,000
Percentage Error	7.60%	-12.40%

It appears that a significant error can occur even when the expensive activities account for about 84 percent of the total overhead.